Sloppy Strikes

OPTION STRIKE PRICES HAVE ALWAYS featured a tidy sequence of easy, logical numbers. Come Monday, however, that orderly alignment gets knocked out of whack -- thanks to
Microsoft.

A special dividend Microsoft plans to pay stockholders is so unusual it requires the option industry to adjust strike prices -- not just for Microsoft options, but also options on many exchange-traded funds (ETFs) that count the software bellwether as a component. Microsoft shareholders last week approved a one-time, $3 a-share payout first announced in July; the stock goes ex dividend Monday, after which stockholders aren't entitled to the dividend, and the stock presumably falls by the dividend amount.

Because the payout is so large relative to the share price, option exchanges will lower Microsoft strike prices by $3 as the stock goes ex dividend. That way, a $30 strike option that was at-the-money when shares traded at 30 remains at-the-money as the stock goes to 27, since the option strike is now adjusted to $27. Microsoft strike prices of $25, $27.50, $30 will become, respectively, $22, $24.50, $27.

That's not all, since Mr. Softy is such a market heavyweight. It is, for instance, a big part of the
Software Holdrs Trust,
or SWH, which expects to pay 90 cents a share to ETF owners. SWH options will be adjusted down by 87.5 cents -- 90 cents rounded to the nearest eighth of a dollar -- when SWH goes ex dividend Monday, and strikes of $30, $32.50, $35 become the rather awkward $29 1/8, $31 5/8, $341/8.

In all, Microsoft is a part of more than 20 ETFs, and traders expect adjustments to heavily traded options, including the
Nasdaq 100 Tracking Stock
(QQQ) and the
Dow Diamonds.
Goldman Sachs option strategist Maria Grant estimates that QQQ options will be adjusted around Dec. 17, with strikes lowered by 37.5 cents. The Options Clearing Corp. says it will adjust all affected ETF options if the exchange-traded fund makes distributions that include proceeds from the Microsoft dividend, and if Microsoft's contribution is at least 12.5 cents a share. Details of each adjustment will be announced when finalized (check www.theocc.com).

Other questions abound, many of which Grant tackled in a research note "Top 10 Options-Related Questions on the Microsoft Dividend." Should holders of in-the-money calls exercise their options? That can sometimes make sense when strikes aren't adjusted for ordinary dividends, when the early exerciser collects dividends rather than watch their call drop in value along with the stock post dividend, Grant says. But that's not the case here.

Lower strikes also could temporarily dampen premiums, Grant says. For example, a 32.50-strike call with stock trading at 29.77 is 9.2% out-of-the-money. Post adjustment, that same 29.50 strike call with stock now at 26.77 becomes 10.2% out-of-the-money. Because the stock now needs to make larger percentage moves to reach target strikes, buyers may feel less inclined to bid up options, and implied volatility could slip in the short term. But over the long run, Grant sees no reason why volatility won't pick up as Microsoft's capital structure changes, and with implied volatility already slumping at multi-year lows.

Away from Microsoft, risk forecast kept up its neat, methodical retreat. The Standard & Poor's 500 stock index climbed above the top of its 2004 trading range, and implied volatility of stock benchmarks shrank toward their nine-year lows. At first glance, this suggests that "not only have downside risk perceptions declined, but upside return expectations have also fallen," notes Credit Suisse First Boston strategist Edward Tom.

But the skew -- which quantifies the demand for out-of-the-money puts versus calls -- collapsed last week. This isn't unusual as investors often unwind put hedges after a big event passes, such as Election 2004. But Tom thinks it also points to an "upward repricing in calls, signaling that market makers may in fact be beginning to position their books for an upside market breakout."

also in some disarray last week was the American Stock Exchange. The SEC served notice that it may file a civil action against CEO Salvatore Sodano, President Peter Quick and general counsel Mike Ryan. SEC investigators previously found the No. 3 U.S. option market had failed to adequately enforce rules about the handling of customer option orders, and may have lied to cover up lapses. The Amex board held an emergency meeting and appointed a special committee to deal with the matter. An SEC spokesman said Friday the trio are still on the payroll and are declining to comment.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.